Taylor on the Crisis

If I could only recommend one economist to read on the current financial crisis, I would choose John Taylor. His latest paper details the causes of the financial crisis as well as the subsequent policy responses (and failures). Here are some highlights:

He presents evidence that the Federal Reserve significantly deviated from its historical behavior (the Taylor Rule), which created the boom-bust scenario in housing.

He presents counter-factual evidence through the use of simulation that suggests the housing boom would have been avoided had the federal funds rate not deviated from the Taylor rule.

He rejects the global savings glut hypothesis.

The behavior of other central banks similarly deviated from the Taylor rule and those with the largest deviations also had the largest housing booms.

There is a connection between excessive monetary policy and risk-taking.

The subprime mortgage market exacerbated the problem.

The financial crisis was (is) not a liquidity problem, but rather a counter-party risk problem.

There is a strong correlation between the sharp cuts in the federal funds rate and the price of oil.

Credit spreads increased in the aftermath of the announcement of the TARP. (Taylor blames this on the uncertainty surrounding the vague discretionary power of the Fed/Treasury in implementing the plan.)

From his conclusion:

“In this paper I have provided empirical evidence that government actions and interventions caused, prolonged, and worsened the financial crisis. They caused it by deviating from historical precedents and principles for setting interest rates, which had worked well for 20 years. They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately by focusing on liquidity rather than risk. They made it worse by providing support for certain financial institutions and their creditors but not others in an ad hoc way without a clear and understandable framework. While other factors were certainly at play, these government actions should be first on the list of answers to the question of what went wrong.”

I am teaching Money and Banking again this semester and this paper will undoubtedly be required reading.